The Art and Pseudoscience of Monetary Policy

Monetary policy is the process by which the monetary authority of a country, like the Federal Reserve in the US or the Bank of England in the UK controls the supply of money, often targeting an inflation rate or interest rate to ensure price stability and general trust in the currency. Other goals include policies that encourage economic growth and stability, lower unemployment and the maintenance of predictable exchange rates with other currencies.

Monetary policy also contributes to economic growth and stability, aims to lower unemployment, and attempts to maintain predictable exchange rates with other currencies. This is not a pure science, but is an art and pseudoscience.

Interest rate change

When monetary policy changes the official interest rate, it is attempting to influence the overall level of activity in the economy in order to keep the demand for, and supply of, goods and services roughly in balance. Doing so results in a rate of inflation in the economy consistent with the policy committee’s inflation target. The Fisher Effect model explains the equation linking inflation with interest rates. The Taylor rule adjusts the interest rate in response to changes in the inflation rate and the output gap.
The mathematical theory is that a reduction in interest rates makes saving less attractive and borrowing more attractive, which stimulates spending. Yet this can not be guaranteed since it is the policy maker that needs to interpret these against predictions of what may happen in the future, and it can only be pseudoscience that can foretell what that will be.

Exchange rates

A rise in the rate of interest in any country relative to overseas would give investors a higher return on assets relative to their foreign-currency equivalents, tending to make home assets more attractive. That should, in pseudoscience terms. raise the value of the home currency, reducing the price of imports and increasing the price of the country’s exports. This reduces demand for goods and services abroad.

Pseudoscience of monetary policy models

Whilst models and theories are used to form monetary policy, the impact of interest rates on the economy and the exchange rate is seldom predictable. Conventional macroeconomic models assume a ‘new classical approach’ where all agents are rational, with clear preferences that enable them to always choose to perform the action with the optimal expected outcome among all possible actions. However, behaviour economics show that people often deviate from neoclassical theory due to time limitations, personal preferences and bias.

Monetary policy relies on data to show if the economy’s heating up or cooling off so that decisions can be made accordingly. Data as to whether GDP growth is increasing or decreasing, the same for the unemployment rate and consumer price inflation. These data points tell monetary policy makers something about how the economy is, which must then be reconciled with what they believe the economy should be. First, they must interpret a variety of data. Yet this data from government departments may not be entirely accurate. For each headline number there are a list of footnotes and qualifiers, including price and seasonal adjustments. These subjective adjustments are a pseudoscience that can greatly affect results

Whilst monetary policy is the final outcome of complex interactions between humans within institutions and central banks with preferences and policy rules, models fail to address the behavioural effects of monetary policy decisions. Also, individuals regularly over-estimate their own ability, competence, or judgements. Central bank policy makers may be overconfident in managing the macro-economy in terms of timing, magnitude and even the qualitative impact of interventions. When policy-makers believe their actions will have larger effects than objective analysis would indicate, this results in too little intervention.

Even if the bureaucrats tasked with it were to completely ignore their personal goals and preferences, even if data was totally accurate, their decisions would still generate outcomes inferior to those produced by an unhampered market economy. Also, short-term effects of monetary policy can be influenced by the degree to which announcements of new policy are deemed credible. When an anti-inflation policy is announced by a central bank, in the absence of credibility in the eyes of the public inflationary expectations will not drop, and the short-run effect of the announcement and a subsequent sustained anti-inflation policy is likely to be a combination of somewhat lower inflation and higher unemployment.

Monetary policy planners work with the data they have to fix the price of money, to influence the economy to their own preferences and bias. This is the art and pseudoscience of monetary policy. Monetary policy analyses should thus account for the fact that policy makers (or central bankers) are individuals and prone to biases and temptations that can sensibly influence their ultimate choices in the setting of macroeconomic and/or interest rate targets.